Berenson the number; how the drive for quarterly earnings corrupted wall street and corporate america (2003)

Yet no one—not the analysts paid to decipher the truth ofComputer Associates’ fortunes, not the accountants legally required to certify its books, not the mutualfund managers who bought

Title Page

Dedication

Epigraph

Prologue: One of Many

Introduction: System Failure

Part I That Was Then

Chapter 1: Boom and Bust

Chapter 2: Foundations

Chapter 3: Bubbling Under

Chapter 4: The Death of Equities

Part II This Is Now

Chapter 5: Countdown

Chapter 6: The Number Is Born

Chapter 7: Options

Chapter 8: Accountants at the Trough

Chapter 9: Archaeologists and Detectives

Chapter 10: Frenzy

Chapter 11: Truth

Conclusion: Look Both Ways

Appendix 1: Accrual Versus Cash Accounting

Appendix 2: Balance Sheets and Income StatementsNotes

Endnotes

Acknowledgments

About the Author

Copyright Page

FOR MY BROTHER DAVID,

A TRUE FRIEND

It is difficult to get a man to understand something when his salary depends on his not understanding it.

UPTON SINCLAIR

One of Many

January 22, 2001, 5:30 P.M. Darkness has settled over the East Coast, but the mood is sunny in theexecutive suites at the Islandia, New York, headquarters of Computer Associates The world’sfourth-largest independent software company has just released its quarterly earnings for the threemonths ending December 2000, and the report is a good one Sales and profits are higher than WallStreet anticipated

No one will benefit from the news more than Charles Wang, the chairman of ComputerAssociates, and Sanjay Kumar, the company’s chief executive, good friends who have just bought theNew York Islanders professional hockey team Wang owns 30 million shares, more than $1 billion,

of the company’s stock Kumar, a relative pauper, has about $200 million in Computer Associatesshares Those fortunes will grow the next day, as investors bid Computer Associates’ stock up almost

6 percent

After issuing the report, Computer Associates holds a conference call to discuss its results withthe Wall Street analysts who follow the company Kumar can’t resist bragging Although the softwareindustry is in its worst downturn in a decade, his company has demonstrated its strength “We’reextremely pleased with the performance we pulled off,” he says.1

If she had been on the call, that news would have come as a surprise to Mary Welch Welch, aComputer Associates sales rep, had been fired by the company a week earlier, one of three hundredemployees laid off as 2001 began Like most of the fired employees, Welch was told she would notreceive any severance pay, because she had been dismissed for poor performance Yet she hadreceived a positive job review only two weeks before Welch and many other fired employeesbelieved that Computer Associates wanted to avoid paying severance by disguising a company-widecutback as individual firings The layoffs were necessary because the company’s sales had plunged inthe December quarter, the fired employees claimed “They did a mass layoff,’’ Welch said

At the time, Welch’s complaints seemed nothing more than the gripes of a disgruntled employee After all, Computer Associates’ financial statements showed that business had been betterthan ever in the December quarter, with sales up 13 percent and profit up almost one-third Surely thecompany couldn’t just make up its results

ex-But Mary Welch was right Thanks to an audacious accounting trick, Computer Associates hadfound a way to rewrite its financial statements The company had divorced the reality of its business,

a business in decline, from the profit-and-loss picture it presented to Wall Street Breaking the mostbasic conventions of accounting, it was rebooking sales and earnings that it had already reported

Computer Associates was not a penny stock operating in the shadows of the market It had

eighteen thousand employees, tens of thousands of shareholders, and a market value of more than $20billion, more than Nike or Federal Express Yet no one—not the analysts paid to decipher the truth ofComputer Associates’ fortunes, not the accountants legally required to certify its books, not the mutualfund managers who bought its stock, and most certainly not the regulators who oversaw the U.S.securities markets—had blown the whistle on the company’s accounting maneuvers.

There are fourteen thousand publicly traded companies in the United States Expecting all of them

to be honest is unrealistic Like any town of fourteen thousand, the market is bound to have its share ofgrifters and shoplifters But the deception at Computer Associates was dangerous precisely because it

wasn’t an aberration By January 2001, all manner of companies were abusing accounting rules to

mislead their investors, seemingly without fear of being caught A strange madness had gripped themarket Even its most solid citizens were running red lights and breaking windows And the policewere nowhere in sight

System Failure

On Wall Street, not all numbers are created equal

New home starts The consumer confidence index Retail sales Overnight television ratings.Unemployment claims PC shipments Casino winnings in Atlantic City and the Las Vegas Strip

The figures roll out every day from government agencies and industry trade groups andindependent analysts Watching them all is impossible; most speed by unnoticed

But one set of numbers burns brighter than the rest Every three months, publicly traded UnitedStates companies report their sales and profits to their shareholders Those quarterly announcementsare the lodestar that investors—and these days, that’s most of us—use to judge the health of corporateAmerica

It makes intuitive sense that corporations must regularly tell their shareholders how much moneythey have made or lost What’s your weekly paycheck? Did you get a bonus last year? All in all, howmuch money did you make? You know the answer, without much trouble Why shouldn’t Exxon andGeneral Motors?

They should, and they do Every quarter they add up their sales and costs, and figure out wherethey stand Then they tell the world, in press releases and conference calls and most important inreports that they file four times a year with the Securities and Exchange Commission, the federalagency that regulates U.S stock markets To be precise: Three quarterly reports, or 10-Qs, submitted

to the S.E.C within forty-five days after a quarter ends One 10-K, the big one, the audited annualreport, to be filed less than ninety days of the end of a company’s fiscal year Qs and Ks, in WallStreet shorthand

Qs and Ks are monuments to numbers Revenue Selling, general, and administrative expenses.Operating income Interest paid Columns of huge numbers, eight, nine, or ten figures long, fall downthe page in black and white to land with a bang disguised as a whimper at one small number: earningsper share

Earnings per share is usually no more than a couple of bucks, an unprepossessing sum compared

to the giant figures above But its small size is deceiving Multiply a dollar or two per share byhundreds of millions of shares, and you have real money A stray penny on the 10 billion shares thatGeneral Electric has outstanding turns out to be $100 million

Even within a profit report, not all numbers are equal For traders and investors of all sizes,earnings per share is the ultimate benchmark of a company’s success or failure Has it risen from theprevious quarter and the previous year? Has it met the “consensus”—the average estimate of the WallStreet analysts who follow the company? More than any other number, earnings per share determines

whether a company’s shares will rise or fall, whether its chief executive will be rewarded or fired,whether it will build a new headquarters or endure a round of layoffs.

On Wall Street, a place of little subtlety, earnings per share is known simply as “the number.” As

in “What was the number for Pfizer?” Earnings per share is the number for which all the othernumbers are sacrificed It is the distilled truth of a company’s health Earnings per share is the numberthat counts

Too bad it’s a lie

Under the best of circumstances, the figures in a quarterly report—earnings per share most of all—areapproximations, best guesses based on a thousand other best guesses Earnings reports are aboutaccounting, and the accounting that big companies use to measure their financial health has as much incommon with the way you balance your checkbook as a five-alarm fire has with a backyard barbecue

If you’re like most people, your paycheck is your main source of income Over the last few years,

if you work for a publicly traded company, you may have gotten some stock options too Those arenice, but the local grocery store prefers cash, so if you’re wise, you won’t figure options as income,either, until you cash them in

Then there’s the other side of the ledger: spending and saving The distinction is usually clear,although the line blurs at your mortgage payment, since part of that is going to build equity in yourhome Still, your personal accounting is relatively straightforward You can easily compare howmuch you’ve earned and how much you’ve spent, because you get paid in cash and you spend cash (oruse a credit card, which you pay off within a few weeks)

But big companies measure their costs and revenues in a very different way Instead of simplycounting the cash they are making and spending, they use something called “accrual accounting.”Under accrual accounting, a company books revenue when it makes a sale, not when it actuallyreceives the cash for the sale It books an expense when it agrees to buy something, not when itactually pays Accrual accounting also recognizes that companies invest in assets that will last manyyears, and it allows the companies to spread the cost of those assets over their life For example, anairline doesn’t expense the entire price of a new plane up front Instead, it recognizes the cost of theplane over many years, as the aircraft’s value “depreciates.”

In theory, accrual accounting makes sense Cash accounting can make companies appear to belosing money just when their business is ramping up and they’re making lots of sales for which they’ll

be paid in the future.*1

But what makes sense in theory can be abused in practice Because they’re not simply measuringcash inflows and outflows, companies need to make hundreds of assumptions to calculate theirearnings each quarter They must estimate everything from how much money they will earn on theirpension funds to how quickly their assets will lose value.†2 With so many assumptions to make, evenhonest companies sometimes make mistakes Those that want to cheat have an almost infinite number

of ways to do so They can book sales to customers who won’t ever be able to pay them They canhide ongoing, day-to-day expenses as investments in long-lived assets They can shift research anddevelopment expenses to supposedly independent partners They can make sham deals with othercompanies, swapping overvalued assets in a way that allows both sides to book a profit on the trade

Used properly, accrual accounting is about timing, not about creating profits where none exists.Over the long run, the profits that a company reports under accrual accounting should jibe with the

cash it receives and spends Over the long run, companies that make sales to customers who can’t paywill have to admit that their clients are deadbeats Over the long run, a company can’t hide operatingexpenses as capital spending, because it will wind up with a balance sheet full of nonexistent assets.Over the long run, all the accounting and financial tricks in the world can’t turn a failing business into

a success

But they can in the short run And sometimes, with enough tricks, the short run can last a long time,long enough for executives to make tens or even hundreds of millions of dollars selling stock whosevalue has been inflated by pumped-up earnings

Given the importance of the number, and the ease with which it can be manipulated, you might expectthat investors would look at earnings per share with a skeptical eye You might think they wouldcarefully read the footnotes buried at the bottoms of Qs and Ks, and examine a company’s cash flows

to see whether its profits have any basis in reality

But you’d be wrong As a rule, before 2002, most individual and professional investors didn’tworry much about accounting As long as a major accounting firm certified that a company’s financialstatements were prepared according to GAAP, or “generally accepted accounting principles,”shareholders took them at face value Investors held as an article of faith that the quality of corporatefinancial reporting in the United States was better than anywhere else Watched over by the Securitiesand Exchange Commission and independent accountants, American companies had no choice but totell Wall Street the truth U.S markets were the fairest and most honest in the world

Like most deeply held beliefs, this shibboleth overlooked inconvenient realities The S.E.C hadnever been given a budget large enough to check every financial statement for irregularities.Accountants had always had to balance their responsibilities to investors with their paychecks, whichcame from the companies whose books they audited

Still, if history was any guide, investors had reason to be confident The combination ofmandatory corporate disclosure and federal oversight seemed to have worked since its creation in

1934 Sure, the concept behind the number—that public companies could precisely calculate theirearnings each quarter—was a lie But as long as companies prepared their financial statements ingood faith, it was a white lie Companies might not always be able to calculate their profits exactly,but if they made honest estimates they ought to be close And for two generations they had been close.Aggressive accounting gimmickry had been uncommon, and overt fraud rare Most financialstatements were reasonably accurate There had been exceptions, especially during the 1960s, butthey never caused investors to question the markets’ overall integrity In fact, in some important ways,markets appeared to be growing fairer as the twentieth century progressed Outright manipulation ofindividual stocks faded, and the S.E.C aggressively pursued insider trading cases

But as the bull market of the 1990s turned into a boom and then a bubble, a few regulators, sellers, and journalists warned that the accuracy of corporate financial statements, the core of thesystem, was slipping Accounting gimmickry had grown widespread and increasingly dangerous, theycomplained The number of earnings restatements soared in the late 1990s, and several big publiccompanies admitted or were caught committing accounting fraud

short-“We are witnessing an erosion in the quality of earnings and, therefore, the quality of financialreporting Managing may be giving way to manipulation; integrity may be losing out to illusion,”Arthur Levitt, chairman of the S.E.C., said in a prophetic 1998 speech in New York “Today,

American markets enjoy the confidence of the world How many half-truths, and how muchaccounting sleight-of-hand, will it take to tarnish that faith?”

But with the Nasdaq and Standard & Poor’s 500 index setting new highs on what seemed a dailybasis, Levitt’s speech, and similar grumblings, were mostly ignored Wall Street, the accountingindustry, and corporate executives insisted the system of oversight and disclosure was as solid asever Most individual investors were inclined to agree, pouring money into mutual funds and theirretirement accounts Wall Street’s complacency about the quality of earnings persisted even after theNasdaq bubble burst in the spring of 2000—and, amazingly, even after Enron collapsed in the fall of

2001 By March 2002, the S&P 500 index, the most important barometer of the overall market, stood

at 1,170, compared to 1,130 when Enron filed for bankruptcy in December

To be sure, at 1,170, S&P 500 had fallen about 24 percent from its peak two years earlier Butthat loss was concentrated in technology and telecommunications companies, which had been crushed

by the slowdown in demand for computers and Internet services Most other stocks had hardly fallen;many had risen from their levels of 2000 Considering that the United States had endured both arecession and a terrorist attack the previous year, stock prices in March 2002 reflected extraordinaryinvestor confidence, a confidence seventy years in the making

In a matter of months, that confidence disappeared During the spring of 2002, dozens of cases ofserious accounting gimmickry came to light at blue-chip, Fortune 500 companies Qwest, a gianttelecom company, said that it had improperly overstated its profits by $1.6 billion Dynegy, an energytrader, admitted that it had inflated its cash flow by hundreds of millions of dollars Bristol-MyersSquibb, one of the world’s largest drug companies, acknowledged juicing its sales figures byencouraging its distributors to buy more product than they needed I.B.M was discovered bookingprofits from asset sales—which by their nature are one-time gains—as operating earnings Everyweek seemed to bring another disaster, another S.E.C or criminal investigation of accountingirregularities: Global Crossing Computer Associates Adelphia Communications AOL TimeWarner Nvidia Halliburton Whole sectors of the market, most notably cable andtelecommunications companies and energy traders, found themselves unable to sell new stock or bondissues at any price, so deeply did investors distrust their financial statements Enron’s auditor, ArthurAndersen, which had eighty-five thousand employees worldwide and a ninety-year history, brokeapart and collapsed after being criminally indicted for obstruction of justice

Then, at the beginning of June, Manhattan prosecutors indicted L Dennis Kozlowski, the chairman

of Tyco International, a huge conglomerate that for months had angrily denied allegations ofaccounting gimmickry, on criminal charges of sales tax evasion (Prosecutors would later expand thecharges, accusing Tyco’s three top executives of stealing hundreds of millions of dollars from thecompany.) Tyco’s stock, which had stood at $60 in December 2001, fell as low as $8 The drop costinvestors $100 billion, more than the collapse of Enron And on June 25, the telecommunicationsgiant WorldCom admitted that it had outstated its profits by $4 billion Less than a month later,WorldCom filed for Chapter 11, the largest corporate bankruptcy in history

For many investors, the revelations at WorldCom and Tyco were too much to bear The scope ofthe fraud at WorldCom was unprecedented, while the charges against Kozlowski put in high relief thegreed that corporate chieftains had shown during the 1990s boom Kozlowski had been one of themost highly regarded executives in the United States only a few months before, fawned over by Wall

Street analysts and the subject of a rave Business Week cover article in May 2001 Now he was being

arraigned in a Manhattan courthouse among petty thieves and drug pushers Could any chief executive

or any financial statement be trusted? Was the spectacular growth that the U.S economy andcompanies like General Electric had shown during the 1990s real or a mirage?

Between March and October of 2002, the Dow Jones industrial average fell more than 2,000points The S&P 500 dropped by about one-third, closing on October 9 at 777, its lowest level in fiveyears In seven months, $4.3 trillion in stock market wealth—$15,000 for every American—simplyevaporated From its March 2000 high, the S&P 500 had fallen nearly 50 percent, the worst bearmarket since the Depression

The crash was particularly difficult for older Americans who had counted on stocks to financetheir retirements “I didn’t want to become one of those doddering old professors who can neverafford to leave,” John Saxman, a Columbia University professor, said in July “Now I’m sixty-three,and every time I try to think about a specific retirement date, I look at my quarterly reports and realize

I can’t.”1 But the pain was not confined to a few or a few million unlucky investors U.S economicgrowth, which had been very strong during the first quarter of 2002, stalled as companies pulled back

on new hiring and new investments in plants and equipment Osama bin Laden had hardly slowed theAmerican economy; Dennis Kozlowski and Bernard J Ebbers of WorldCom and Kenneth Lay ofEnron brought it almost to a halt

I first considered writing this book in the fall of 2001 when Enron collapsed As a financial

investigative reporter at The New York Times, I had seen plenty of bad accounting and corporate

fraud Still, I was stunned to see a company as large and supposedly as profitable as Enron implode

in a matter of months Sure, big companies had gone bankrupt before But usually there were plenty ofwarning signs, and the problems were easy to understand, if not to fix A labor war had destroyedEastern Airlines; heavy debt from a hostile takeover had forced Federated Department Stores, theowner of Bloomingdale’s and Macy’s, into bankruptcy Enron, however, had just disappeared Theassets that it listed on its books didn’t seem to exist at all

So I was taken aback when the market ignored Enron’s collapse As I began writing in the spring

of 2002, I expected I would have to offer lots of specific examples to convince readers that theproblem of bad accounting had become pervasive But Tyco and Global Crossing and the rest of therogues made that case beyond a reasonable doubt The most important question now is not whathappened at WorldCom or Enron or Arthur Andersen or any individual company or accounting firm

It is why the system as a whole failed, why accounting and financial reporting at so many companiesbecame criminally shoddy

The answer has many threads The ethical collapse of the accounting industry, vast increases inexecutive pay, and severe budget problems at the S.E.C contributed to the crisis The decline in WallStreet research, the extraordinary growth of mutual funds, and investors’ insatiable demand forInternet stocks also played a part Even the falling cost of trading stocks can be counted as an indirectcause And in the final two-thirds of this book, I’ll offer a comprehensive look at the changes of thelast two decades

But to truly understand what happened at the end of the 1990s, investors need to look back furtherthan the beginning of the most recent bull market in 1982 The real answer requires a (brief)explanation of the history of accounting and Wall Street in the twentieth century, beginning with theboom and bust of the 1920s and the creation of the S.E.C in 1934 For the seeds of the system’s

failure were present from the very start.

Part I

That was Then

Chapter 1

Boom and Bust

It had been a very long week for J P Morgan Jr

Morgan—the world’s leading financier, the personification of Wall Street—had endured days oftestimony before the Senate Banking and Currency Committee about his firm’s misbehavior during the1920s boom and the crash that followed Under pointed questioning by Ferdinand Pecora, a hard-charging New York prosecutor who was the committee’s chief counsel, Morgan admitted that he andmany of his partners had not paid any taxes in 1931 and 1932, with the Depression at its worst Heacknowledged that earlier, at the height of the bubble, his firm had offered government officials thechance to buy shares in a hot new company at a below-market price With 25 percent of allAmericans unemployed, with banks failing and farmers starving, these revelations did not elicit great

warmth A generation later, The New York Times would call the inquiry “remarkable for its

unfriendliness even in that year of bankers’ general unpopularity.”1

That year was 1933 And on the first day of its sixth month—Friday, June 1—at 10 A.M., in aSenate hearing room crowded with reporters and photographers, Morgan and his aides waited foranother difficult day to begin

Then the midget showed up

The reason Lya Graf came to the Senate that day has been lost to history Her employer, theRingling Brothers and Barnum & Bailey Circus, was in town, but Graf had no obvious reason to makeher way to the Capitol Perhaps Ringling was looking for some easy publicity; a Ringling press agentnamed Charles Leef had accompanied her Perhaps she just wanted to see Morgan in the flesh If so,both circus and midget got their wishes Ray Tucker, a reporter for the Scripps-Howard newsservice, saw Graf in the crowd outside the hearing room and pulled her in “I’m going to introduceyou to J P Morgan,” Tucker said And he did Photographers swarmed and reporters rushed tocapture every word of the not-very-interesting conversation between Morgan and Graf (Morgan: “Ihave a grandson bigger than you.” Graf: “But I’m older.”) Then Leef, the press agent, picked up Grafand popped her onto Morgan’s lap

In pictures of the incident, Morgan looks stunned and Graf amused, her arms spread wide.2Richard Whitney, the president of the New York Stock Exchange and a Morgan flunky, quickly sentGraf off, and Morgan recovered his composure

But he could not recover his reputation In a moment he was transformed from a powerfulplutocrat to a confused old man It is impossible to imagine Morgan’s father, the original J.P., whohad been America’s central banker before America had a central bank, being caught in a similarindignity Morgan Sr ended market panics, steadied the economy, and saved Wall Street from itself;

he did not truck with midgets, or senators Morgan Jr could not stop the crash of 1929 or end theDepression He had tried and failed For that Morgan might have been forgiven—the economic crisiswas too big for any private citizen to fix—but he and his well-paid factotums had failed in a second,inexcusable way They had failed to understand how serious the Depression had become and howmuch America now distrusted financiers and big business And so Morgan and the rest of WallStreet’s Old Guard had become nearly irrelevant to the bitter national debate over how to savecapitalism from itself Commentators wrote later that the incident had “humanized” Morgan, as if aman who treasured power and discretion, whose firm did not advertise or even put its name on itsfront door, wanted to be humanized As if humanization was not the ultimate embarrassment.

A midget sat on J P Morgan’s lap It would be two generations before Wall Street and corporateAmerica again ran so far amok during a boom or were so badly humiliated in the bust that followed

A few years before that Friday morning, the nation’s attitude toward Wall Street had been very

different In Once in Golconda, John Brooks summed up the peak of the frenzy as well as anyone ever

has, in words eerily familiar today:

Let us try, as best we can, to look at Wall Street as it was in August 1929, to catch itsessentials Newcomers have arrived in great numbers They are men and women who aresacrificing their own vacations, or else have simply chucked their jobs, to spend their dayssitting, or more likely standing, in the brokerage customers’ rooms watching the quotationboard report the glorious news

Many of those now crowding Wall Street have burned their bridges They have thrownover their jobs on reaching some predetermined goal, a paper net worth of $50,000 or

$100,000 or $200,000; they have bought expensive houses and mink coats for themselves ortheir wives, and look forward to lives of leisure and affluence

All through the days, and long into the evenings, the talk, talk, talk goes on There are tales

of fortunes just made and of fortunes about to be made—above all, talk of fortunes There

is talk about John J Raskob’s article in that month’s Ladies’ Home Journal entitled

“Everybody Ought to Be Rich .”

On the seventeenth the Ile de France and the Berengaria depart on transatlantic trips, the

former eastward and the latter westward, each fully equipped for speculation with floating

brokerage offices; when the Berengaria arrives in New York six days later, passengers tell of

how every day the office on the promenade deck has been so mobbed that quotations had to bepassed by word of mouth to passengers who couldn’t get near enough

The madness had been a decade in the making From a low of 63.90 in 1921, in the deeprecession that followed the Great War, the Dow Jones industrial average had climbed steadily higher

By 1925 the Dow had more than doubled After a pause in 1926, it leaped ahead again, finallyreaching 381.17 on September 3, 1929 In eight years the Dow rose sixfold, by far the greatest gain inthe history of the index up to that point

In the generations since, economists and financial historians have exhaustively parsed the boom.Most have agreed broadly on its causes, from easy margin requirements that encouraged speculation

to technological advances that spurred economic growth and brought electricity and cars to millions

of Americans.*3 But there was at least one more factor in the decade-long rally, one less widely

discussed When the bull market began, stocks were cheap.

In the early 1920s, prudent investors usually stayed away from stocks, buying bonds instead.Many investors viewed the New York Stock Exchange and its weaker cousin, the Curb Exchange, aslittle more than casinos And they were right to be cynical Trading on inside information wascommon, and stock manipulation widespread; stock prices would swing wildly on rumors of “bearraids” and “short squeezes.”*4 “All the bubble blowers of other days, the moonshine promoters,green goods, and shell game men, financial pan-handlers and wildcat exploiters, and skin-gamefakers are now engaged in the stock selling game,” a Pennsylvania congressman thundered in

1919.3

Nor could investors expect much protection from the authorities State regulation was minimal;despite the congressional bluster, federal laws against stock manipulation hardly existed The NewYork Stock Exchange, popularly known as the Big Board, functioned more or less as a private club,following its rules sporadically—usually when their enforcement would benefit its members Even

the press, that beacon of democracy and fair play, could not be trusted Financial reporters from The

Wall Street Journal and The New York Times were later discovered to have taken hundreds of

thousands of dollars in bribes in return for pumping stocks in print.4

“Nearly all of those who traded in stocks frankly called themselves speculators,” BenjaminGraham, the first and greatest stock analyst, wrote of the era in his memoirs “They did not draw toofine a distinction between their financial operations and racetrack or other betting.”5 In fact, Grahamrecalled drolly, before the 1920s brokerage firms routinely handled bets on the outcome ofpresidential elections for their clients, but “this genial practice was outlawed some years later whenthe stock exchange went all out for respectability.”

A dearth of reliable financial information about companies contributed to the market’s goes nature A few years before, Morgan Sr had bemoaned the day when “all business will have to

anything-be done with glass pockets.”6 He need not have worried The attitude of bankers and executives wasthat investors should cash their dividend checks and keep their questions to themselves (In 1899,Henry Havermeyer, the president of the American Sugar Refining Company, was asked if he thoughtthat corporations had the right to “offer stock to the people—to the whole community—and that thecommunity then has no right to a knowledge of what the earning power of the stock is.” In the bestnineteenth-century robber-baron style, Havermeyer replied, “Precisely.”)

The Big Board did not even require the companies it listed to report their profits to investors Itdid make companies provide shareholders with a balance sheet listing assets and debts at least once ayear.*5 Most companies went beyond that minimum, putting out an income statement at least once ayear But they often took the notion of an income statement quite literally, telling shareholders howmuch money they had made or lost—and nothing more At least one company, Pocahontas Fuel,offered investors only its balance sheet Fewer than half the companies on the Big Board providedshareholders with full financial statements, including sales, interest costs, dividends and taxes paid,and one-time gains and losses.7

“It is not an exaggeration to say many corporate executives and investment bankers elevatedopacity to a hallowed business principle,” a trade group of financial analysts would later complain

“Information, such as it was in businesses beyond the railroads, was guarded jealously andunderstood to be emphatically private Good information was almost by definition ‘inside’information.”8

So it is no surprise that many investors avoided stocks entirely as the 1920s began But not everystock was rigged, and most companies were not frauds The market’s grime hid spectacular bargains

in first-rate companies like U.S Steel, which had been profitable and paid regular dividends throughgood years and bad Their prices look almost absurdly low today

The most basic measures of stock valuation are the dividend yield and the price-earnings (P/E)ratio The dividend yield measures how much cash a shareholder receives each year, relative to theprice of a share of stock For example, if General Motors trades for $100 and pays an annual $4dividend, G.M has a dividend yield of 4/100, or 4 percent The P/E ratio compares the price of ashare to annual profits per share If G.M made $8 a share last year, it has a price-earnings ratio of100/8, or about 12.5

P/Es and dividend yields rise and fall with interest rates, economic growth, and investorconfidence But in general, low P/E ratios and high yields are a sign that stocks are cheap compared

to alternative investments like bonds or real estate Over the last century the average P/E of bigAmerican stocks has been about 15, and the average yield 4 percent But that average figure hasmasked wild swings, and P/Es have rarely been lower, or yields higher, than they were in the early1920s General Electric, paying a dividend of $12 a share in 1921, could be had for $110, a yield of

11 percent Overall, at a time when high-quality bonds paid 5 percent, the market’s P/E ratio wasbelow 10, and its dividend yield above 6 percent.9

With bargains like that at a time when the economy was growing solidly and inflation was quiet,stocks were all but certain to rise

Rise they did, haltingly at first, then with increasing confidence as the decade progressed And ascompanies like General Motors and Radio Corporation of America reported soaring sales andprofits, investors realized something exciting about stocks that they had hardly understood before As

the economist Edgar Lawrence Smith explained in a 1924 book, Common Stocks as Long-Term

Investments, a stock was not just a junior-grade bond that needed to pay a high dividend to

compensate investors for its extra risk Bonds paid fixed interest rates But dividends on a stock werenot fixed They could rise as a company expanded and became more profitable Bonds might offersafety, but stocks offered growth In fact, if a company was growing quickly, it might be toshareholders’ advantage to accept a low dividend now so that the company could reinvest its cash inits business and make much more money later

Other economists and academics, such as Yale’s Irving Fischer, seconded Smith’s optimisticview And investors saw for themselves how quickly companies could grow in a strong economy.Between 1915 and 1926, profits at the Computing-Tabulating-Recording Company (which laterwould change its name to International Business Machines) rose from less than $700,000 to $3.7million, a fivefold increase.10 C-T-R’s dividend more than tripled, and its stock rose at a similarpace

“During the postwar period, and particularly during the latter stage of the bull market culminating

in 1929, the public acquired a completely different attitude toward the investment merits of common

stocks,” Graham wrote in 1934, in the first edition of Security Analysis, his seminal work on stock

valuation (Graham, who at the time was managing money and teaching a class at ColumbiaUniversity on investing, coauthored the seven-hundred-page book with David Dodd, a Columbiaprofessor.) “The new theory or principle may be summed up in a sentence: ‘The value of a common

stock depends entirely upon what it will earn in the future.’”11

And as Graham noted sardonically, once that principle was established, investors could justifypaying almost any price for a fast-growing company Investors no longer needed to research thequality of a company’s management, whether its stock was too expensive relative to its growthprospects, or whether a bond might be a better investment “Making money in the stock market wasnow the easiest thing in the world It was only necessary to buy ‘good’ stocks, regardless of price,and then to let nature take her upward course,” Graham wrote He was especially critical ofinvestment trusts, the predecessor of mutual funds, which became very popular in the late 1920s.12

“The investment process consisted merely of finding prominent companies with a rising trend ofearnings, and then buying their shares regardless of price Hence the sound policy was to buy onlywhat everyone else was buying The original idea of searching for the undervalued and neglectedissues dropped completely out of sight.”

What was true for professional investors was doubly true for individuals Americans in the 1920shad lived through repeated market panics and recessions so deep they would be called depressionstoday They had watched the New York Stock Exchange close for four months in 1914, after warbegan in Europe To the extent they had paid attention to the market at all, they had seen that it was adangerous place for outsiders, a place where manipulation was rampant and outright fraud notuncommon Yet, as the bull market progressed, it took a remarkably short time—years, not decades—for small investors to put aside their fears and plunge into the market Millions of Americansenthusiastically bought stocks, and many sought out the fastest-growing, riskiest issues, such asR.C.A and Electric Power & Light and Wright Aeronautical Corporation, which rose from $8 a share

in 1922 to $280 a share in 1928

If there was one moment that signaled the beginning of the transition from bull market to bubble, itwas August 2, 1926 On that day the Dow Jones financial news service reported that ThomasCochran, a Morgan partner, had said that “General Motors running at its present rate is cheap at theprice, and it should and it will sell at least one hundred points higher.”13 For a man of the House ofMorgan to tout a stock publicly was unusual, to say the least, and G.M stock promptly rose 11½points, or more than 6 percent A few days later G.M announced it would split its stock 3 for 2 Itsshares surged again The boom had begun

It continued for the next three years, fueled by margin and easy credit and talk of a new era ofprosperity Americans should “regard the present with satisfaction and anticipate the future withoptimism,” President Calvin Coolidge said in December 1928.14 Somewhere along the way, thepublic seemed to forget that investment was risky and speculation more so, that stocks could fall aswell as rise The games being played by market manipulators like Jesse Livermore and MichaelMeehan became paradoxically reassuring Wall Street might be a casino, but it was a casino riggedfor the benefit of all its players, a money machine that would never stop giving “Many speculatorscame to believe that a few powerful individuals were able to cause prices to rise and fall almost atwill and that the Exchange would not prevent them from so acting,” Robert Sobel, a financialhistorian, wrote in a chronicle of the era “In large measure they were right.”15

Were investors clamoring for companies with uncertain pasts but bright futures, companies whoseshares could double one month and double again the next? Then Wall Street would give them what

they wanted, and more, without looking too closely at what it sold.

Top-tier banks like Morgan had once hesitated to underwrite (a fancy word for sell) offerings ofnew or risky companies Historically, the banks had been the most important gatekeepers againstfraud, putting their reputations behind the stocks and bonds they sold But as the boom progressed, thelure of high underwriting fees led the banks to lower their standards By the late 1920s, even the mostprestigious firms had succumbed to their own worst instincts and were pumping out dubious issues.The National City Company, a corporate forerunner of today’s Citigroup, had sold Peruviangovernment bonds even though its own experts had warned that they might not be repaid Goldman,Sachs poured out investment trusts whose main function appeared to be buying shares in otherinvestment trusts In less elevated circles that capital structure might have been called a Ponzischeme Lee, Higginson & Co., a reputable New York broker, sold almost $150 million in securitiesfor Ivar Kreuger, “the Swedish Match King,” without bothering to examine the Match King’s books,which were utterly fictitious “You Swedes are blockheads,” Kreuger, perhaps the greatest con man

of the twentieth century, told a friend “You haggle about giving men money But when I get off theboat in New York I find men on the pier begging me to take money off their hands.”16

Kreuger was not alone In 1924, investment banks and companies sold about $800 million instock to the public By 1929 stock sales had soared tenfold, to $8.2 billion.17

Along with the flood of new issues came a flood of accounting gimmicks, often invisible toinvestors until much later, that companies used to inflate their reported profits.18 Like John Brooks’sdescription of Wall Street’s atmosphere in August 1929, many of the tricks will ring familiar tosophisticated investors today Companies:

• hid ongoing expenses in large one-time charges;

• failed to account for losses that their subsidiaries had suffered, or passed money to subsidiaries thatthe subsidiaries then returned to them as profit;

• avoided accounting for their advertising expenses by claiming that advertising has a long-termbrand-building effect and that spending on it should be treated like spending on a new factory,which will be valuable for many years and is not immediately expensed;

• wrote up assets and claimed that the assets’ increased value represented a profit;

• understated depreciation and amortization charges;

• sold assets and pretended that the proceeds from the sales were actually profits from operations

As ever, the chicanery was justified by its practitioners with the excuse that mere financialstatements could not capture the brilliance of their enterprises Talking to a Swedish diplomat, theMatch King spoke for con men everywhere:

We’ve chosen some new high priests and called them accountants They too have a holy day

—the 31st of December—on which we’re supposed to confess In olden times, the princesand everyone would go to confession because it was the thing to do, whether they believed ornot Today the world demands balance sheets, profit-and-loss statements once a year But ifyou’re really working on great ideas, you can’t supply those on schedule

The December ceremony isn’t really a law of the gods—it’s just something we’veinvented All right, let’s conform, but don’t let’s do it in a way that will spoil our plans Andsomeday people will realize that every balance sheet is wrong because it doesn’t containanything but figures The real strengths and weaknesses of an enterprise lie in the plans

The banks and investors who sent Kreuger $650 million during the 1920s and early 1930s might

have disagreed But without reliable, independently audited financial statements, without laws tocompel disclosure and regulators to enforce those laws, investors had no way of knowing thatKreuger had lost hundreds of millions of dollars in his quixotic attempt to corner the world’s matchproduction If they wanted to buy stocks, investors had little choice but to take companies’ reportedprofits on faith.

So they did And the bubble grew

But the trouble with bubbles the trouble with bubbles is that they don’t last Too bad, becausethey are so exciting before they burst A few hundred dollars today turns into thousands tomorrow;and with margin and luck, those thousands turn into tens of thousands The dice stay hot and the sevenskeep coming, not for a night but for a year or two or three

Hush thee, my babe, Granny’s bought some new shares,

Daddy’s gone out to play with the bulls and the bears,

Mommy’s buying on tips, and she simply can’t lose,

And baby shall have some expensive new shoes!

the Saturday Evening Post wrote in September 1929.19 And bubbles don’t seem like luck, not whilethey’re happening It seems only right that the optimists are winning and the whiners ground to dust.Bubbles are the home team running up the score in front of a cheering crowd, Studio 54 circa 1978,except without the velvet rope Everybody gets in

But bubbles never last The dream of the boom is that every idea is a winner, that “it is onlynecessary to buy good stocks,” that profits will always be higher tomorrow than today The reality ofbusiness is false starts, dashed hopes, wasted effort, ruinous competition Eventually the gap betweenfantasy and reality grows too big to ignore Sometimes the bubble bursts because of an event outsidethe market, a war or oil embargo Sometimes investors simply decide—seemingly all at once—thatthey would be better served buying bonds or real estate or anything but a stock trading at one hundredtimes earnings Either way, the bubble bursts, badly

The bubble of Morgan and Coolidge and R.C.A and National City burst on Tuesday, October 29,

1929, eight weeks after the Post’s poem The market had fallen through October and barely avoided

chaos five days earlier, on Black Thursday, when stocks plunged in the morning and the Big Board

closed its visitors gallery to prevent a riot But the bulls still had hope The Wall Street Journal

explained optimistically on October 21 that “thousands of traders and investors have been waiting for

an opportunity to buy stocks on just such a break as has occurred over the last several weeks.” EvenBlack Thursday had ended ambiguously, with the market recovering after Morgan Jr created a $20million buying pool to support blue-chip stocks Investors can buy good companies “with the utmost

confidence,” The New York Times told readers on October 28.20

Then came Black Tuesday This time, no one could stop the panic Investors who had bought onmargin were forced to sell to repay their loans; buyers disappeared The selling engulfed blue chipsand speculative names alike More than 16 million shares were traded on the New York StockExchange, a record that would not be surpassed for more than forty years

By mid-November the Dow Jones average had fallen below 200, losing half its value in two months.The market rallied into the spring of 1930, regaining some of its losses, but the fever had broken

Investors could no longer pretend that stocks only went in one direction Then calamity struck, as theUnited States slid into an economic crisis that worsened by the month Unemployment soared;industrial production plunged; nervous consumers stopped spending The economy fell into paralysis

as fear fed on itself

Most economists now believe the crash did not cause the Depression A far more important factorwas President Herbert Hoover’s stubborn refusal to increase federal spending as demand elsewhere

in the economy collapsed Chaos in the banking system and ill-timed tariff hikes worsened the crisis.But those factors would only be understood later At the time, many Americans blamed Wall Streetfor their misery After all, business had seemed strong before October

Throughout 1930 and 1931 the economy worsened and the market slid By June 1932 the Dow hadfallen to 41.22, its lowest level since 1897 As each month brought more bad news, as productioncollapsed and the unemployment rate rose to 25 percent—one in four adults out of work—thepublic’s anger at Wall Street grew It was easy to see the market’s relentless decline as a plot todestroy the economy Someone must be getting rich off the crash: speculators, short-sellers,

communists, someone Hoover threatened to take over the New York Stock Exchange if the Big Board

did not take action to stop short-selling One senator proposed a bill that would have made shorting acriminal offense “Wall Street was like a trapped animal: what remained of its spirit was contained in

a sullen, dangerous self-protectiveness,” Brooks wrote later On March 12, with his empirecollapsing, Ivar Kreuger shot himself in the heart in a Paris hotel “I have made such a mess ofeverything that I believe this is the best solution for all concerned,” he wrote “Good-bye now, andthanks.”21

Such was the atmosphere in April 1932 when the Senate Banking and Commerce Committeeopened a hearing into Wall Street with a grilling of Richard Whitney, the president of the New YorkStock Exchange The Senate’s inquiry initially focused on the short-selling that Washington heldresponsible for the economy’s woes That line of questioning proved largely futile But when theSenate turned its attention to the manipulation, deception, and greed that had run rampant during the1920s, the show got much more interesting For the next two years the hearings shined a harshspotlight on the ways that securities firms and companies had profited during the boom

The hearings also revealed some seamy corporate accounting tricks (For example, the InsullUtility Investment Company, an electric power holding company, had used a variety of gimmicks toreport a profit of $10.3 million to shareholders in 1930 while posting a loss of $6.5 million on its taxreturns.) As the testimony flowed, the public’s disdain for financiers reached new heights EvenRepublicans, Wall Street’s traditional allies, said they were disgusted with what they had learned “Ifthe turmoil in the courts and in the Congressional committees stops, changes, or modifies the greatthimble-rigging game of Wall Street, the depression of the last four years will have been worth all itcost,” wrote William Allen White, a Kansas newspaper publisher who was a powerful voice in theG.O.P.22

The arrogance and inflexibility that Wall Street displayed in the face of the revelations only madematters worse Securities firms seemed to believe they had no responsibility to make sure that thestocks they sold offered a fair opportunity for long-term gains In their view, they had done nothingmore than meet the demand for new issues Clarence Dillon, the senior partner at Dillon, Read,summed up the Street’s attitude Dillon said he believed his firm had done nothing wrong in takingthree-quarters of the profits of the investment trust it had sold, even though it had put up only a

fraction of the trust’s capital “We could have taken 100 percent,” Dillon said “We could have takenall that profit.”23 In another incident, Whitney, the president of the Big Board, was confronted in NewYork by two Senate investigators after he refused to forward a questionnaire from the Senate tomembers of the exchange “You gentlemen are making a mistake,” he said “The Exchange is a perfectinstitution.”24 It was a line he would not be allowed to forget.

To be sure, investors had been greedy during the 1920s, and many had willingly overlooked flaws

in the market as long as it was rising But not everyone who bought stocks was a speculator Manyinvestors had believed that stocks backed by first-tier firms offered some guarantee of safety—abelief encouraged by firms like Chase and National City, which had held themselves up as moreresponsible than no-name brokerage firms or bucket shops “When you invest through The NationalCity Company you have the benefits of its broad experience [and] its willingness to analyze yoursituation thoughtfully before making recommendations,” National City had cheerily advertised.25 Nowinvestors were discovering, not for the first time or the last, that they could not depend on Wall Street

to protect them

The hearings had their share of political grandstanding, but they also revealed serious problemswith stock sales and trading and an urgent need for new laws If securities firms could not policethemselves, then the federal government would have to protect investors from fraud and manipulation.For the first time, J P Morgan and his neighbors on Wall Street would—at least in theory—have

a master

Chapter 2

Foundations

The Senate’s hearings produced three laws: the Securities Act of 1933, the Glass-Steagall Act, andthe Securities and Exchange Act of 1934 Together they gave the government broad new powers overWall Street

The 1933 Securities Act required companies to file “registration statements” with the governmentbefore they sold shares Corporate executives, investment bankers, and auditors were legally required

to make sure that the information in a registration statement was true and did not omit any importantfacts about a company’s financial health Glass-Steagall forced financial institutions like J P Morgan

to choose between investment banking, such as selling stocks, or commercial banking, such as takingdeposits and making loans The 1934 Securities and Exchange Act created a new federal agency, theSecurities and Exchange Commission, to oversee the securities business The bill also:

• sharply limited short-selling;

• gave the Federal Reserve the power to set margin requirements for stock purchases, so that brokerswould not be able to lend speculators 80 percent or 90 percent of the value of the shares theybought;

• forced directors and corporate executives to report purchases or sales of their companies’ shares;

• required companies on the New York Stock Exchange to file audited annual reports of their salesand profits with the S.E.C

Viewed one way, the new rules were radical For the first time, corporate America and WallStreet were required to provide investors with complete, accurate information But from anotherperspective, President Franklin D Roosevelt had been quite conservative Some New Dealerswanted more than disclosure rules They wanted the federal government to have the final say on whatstocks could be sold “Demand must be gauged in advance by experts,” Rex Tugwell, a ColumbiaUniversity economist, wrote in 1932.1 William O Douglas, who would become the S.E.C.’s thirdchairman, complained that the 1933 law would not “control the speculative craze of the Americanpublic” and that it was “wholly antithetical to the program of control envisaged in the New Deal.”2But that freedom was exactly the point Even in the depths of the Depression, Roosevelt neverseriously considered trying to take control of Wall Street Investors would still be allowed to maketheir own mistakes Disclosure, yes; central planning, no

Morgan et al did not exactly offer Roosevelt heartfelt thanks for his moderation Despite theboom and bust, despite the revelations of insider trading and executive misbehavior, many WallStreeters still believed that the market could regulate itself Through 1933 and 1934, investmentbankers went on a “capital strike,” refusing to underwrite new stocks and bonds.3 (The protest was

made somewhat less effective by the fact that no one wanted to buy anyway.)

The New York Stock Exchange was hardly more cooperative In 1935, led by Richard Whitney,the exchange overwhelmingly rejected as its president a reform candidate who had promised to workmore closely with Washington For the next three years, as the S.E.C tried to tighten rules on tradingand short-selling, the exchange bucked the commission at every turn The sparring continued untilMarch 1938, when the Big Board disclosed that Whitney had embezzled more than $1 million from it.The news left the Exchange’s reputation in tatters and gave it little choice but to accept stricteroversight “Wall Street could hardly have been more embarrassed if J P Morgan had been caught

helping himself off the collection plate at the Cathedral of St John the Divine,” the Nation wrote.4

One month later, Whitney pled guilty to fraud charges He would serve more than three years in SingSing

Facing a serious threat of a federal takeover, the exchange replaced most of its directors and hiredWilliam McChesney Martin as its president Martin, who did not drink, smoke, or gamble, wasWhitney’s antithesis, a sober man for a sober time “He does not belong to any of the swanky NewYork clubs, does not fraternize with powerful bankers and promoters, and aside from his time inthe theatre, the tennis court, and church, he spends most of his spare moments in his room as astudent,” one appreciative reporter wrote

But for the S.E.C., Whitney’s ouster was a Pyrrhic victory Under Martin, the exchange did makesome minor rule changes, but its basic structure remained intact More important, by focusing soclosely on the Big Board, the S.E.C lost the chance to take greater control over corporate governanceand accounting standards.*6

The commission was aware that strong, uniform accounting rules would be crucial if investorswere to compare financial statements from different companies And the agency knew that accountantsoften buckled to pressure from their corporate clients and signed off on gimmicks that distorted profitreports In December 1936, James Landis, the S.E.C.’s second chairman, had complained thataccountants’ “loyalties to management are stronger than their sense of responsibility to the investor.”5Three years later, after leaving the commission, Landis would be more blunt: “What is really needed

is a good spanking for the accountants as a whole.”

Douglas, who followed Landis as chairman, asked the S.E.C.’s chief accountant to prepare astudy of accounting practices as a first step in making them more conservative and consistent “TheCommission must be the pacesetter in the accounting field,” Douglas said at his inaugural pressconference

But the study languished, and the fight with Whitney consumed Douglas’s attention Within a fewmonths, the agency had backed off its plans for stricter oversight of accounting “One need onlyrecognize that the principles of the science of accounting are in a state of flux to be hesitant inwresting guardianship from the hands of the profession,” commissioner George Mathews wrote in

1938.6

At its moment of maximum influence, the commission had allowed Whitney to set its mission for

it, with enormous long-term consequences For most of the next two generations the agency woulddefine its role narrowly, focusing on the exchanges and small-scale stock fraud instead of watchingout for systemic problems with accounting or corporate governance

Too bad, because accounting had plenty of systemic problems that needed fixing.

Despite its importance to capitalism, accounting exists almost in a vacuum Its past has hardlybeen studied; historians have inexplicably focused on Napoleon and Stalin instead of Arthur

Andersen and Luca Pacoli, the Italian monk who in the late 1400s wrote Summa, the first treatise on

bookkeeping As lovable as investment bankers, as charismatic as insurance agents, accountants

“walk in the shadow of virtual anonymity So discreet are they that at times it seems as if their aim

were to become a disembodied function, almost without a proper name,” Fortune wrote in 1932, and

not much has changed.7

Yet accounting deserves more attention than it has received Accountants are the plumbers ofcapitalism, unappreciated but vital to the system The transition to an industrial economy during thenineteenth century meant that businesses could no longer easily finance themselves To build arailroad line or expand a factory, entrepreneurs had to raise capital from outside investors, and thoseoutside investors needed reliable financial information to decide where to put their money But theproto-accountants of the era quickly discovered that calculating a factory’s profit was much moredifficult than figuring out the financial position of small stores or farms that were run more or less on

a cash basis For those firms, accounting was easy: Total up the income received over the course of ayear, subtract the expenses, and end up with profit On the other hand, factory owners were constantlybuying new machines, investments that might take years to pay off At the same time the equipment thatthey had already installed was slowly wearing out So they might be making profitable sales at a timewhen they seemed to be burning through cash—or they might apparently be making money but inreality not be covering the costs of replacing their machines

Accountants in Britain and the United States grappled with these issues throughout the nineteenthcentury Progress was hardly smooth An 1844 letter to a U.S accounting journal complained that thewriter had received forty-three different answers to a question he had previously posed in the journal

“How strange that no two of your correspondents agree, either in details or in practical results,” thewriter said, calling accountants “lamentably deficient.”8

But by century’s end, accountants had found solutions to most of the questions Companies wouldhave to take charges for “depreciation” to measure the falling value of their assets Their bookswould be kept on an “accrual” rather than a cash basis, with expenses and revenues booked whenthey were incurred rather than when cash was actually received or spent Perhaps the most importantinnovation came in 1880, when Charles Ezra Sprague created the template for the modern balancesheet Sprague explained that a company’s assets must always equal its liabilities, including itsequity “What I have equals what I owe plus what I am worth,” Sprague wrote—a formulation thatseems obvious now but was a breakthrough at the time.9

These nineteenth-century accountants did not always know the best way to balance the books Butthey were clear, clearer than they have ever been since, that they owed their allegiance to investors,not to management The reason is simple: The United States depended on Britain for much of itscapital, and many of the first American accountants were British, sent over by British banks andinsurers who wanted to protect their investments They were paid by, and answered to, theircountrymen, not the American companies whose books they audited.10 For the first and only time,accountants did not have to worry about being fired for doing their jobs too well As one auditorproclaimed in 1896:

The professional accountant is an investigator, a looker for leaks, a dissector, and a detective

in the highest acceptation of the term; he must have a good knowledge of real estate,machinery, buildings, and other property His business is to verify that which is right and todetect and expose that which is wrong; to discover and expose facts which exist, whether they

be plainly expressed by clear and distinct records or whether they be concealed by thecunning knave or hidden under plausibly arranged records or as is frequently the case omittedfrom the records entirely He must interpret, rearrange, and produce in simple but distinctform, self-explanatory and free from mysteries of bookkeeping, the narrative of facts

He is the foe of deceit and the champion of honesty.11

But this halcyon state did not last By the end of the century the U.S stock and bond markets haddeveloped enough that American companies no longer needed British capital Instead of depending on

a few large investors, companies began to raise money from smaller investors who had no choice but

to take their financial statements on faith Sure, investors could still ask that companies have theirbooks certified by outside accountants, but those accountants would be hired by and paid by thecompanies themselves No longer would an accountant be truly independent

A century later, accountants still face the tension of serving two masters But instead of owning up

to the problem and accepting that strong rules are necessary to mitigate it, accountants have chosen topretend that the conflict doesn’t exist and fought repeated efforts to make them answer to anindependent regulator Despite reams of evidence to the contrary, they have insisted that their ownethics and professionalism will ensure that they fulfill their responsibilities to investors

Simultaneously, in a stroke of what can only be called genius, accountants have managed to definethose responsibilities so narrowly that they are basically meaningless

Throughout the first decades of the twentieth century, accounting trade groups argued thataccounting was an art, not a science, and that they needed flexibility to make the best judgments fordifferent situations “Accountancy never was or could be an exact science, and every profit or

loss is in very substantial measure an expression of opinion,” the Journal of Accountancy wrote

in 1912 More than pride underlay this dogma If accounting was merely a matter of working through astep-by-step checklist, then companies might replace accountants with lower-paid clerks, as hadhappened in the railroad industry after the Interstate Commerce Commission required uniformreporting procedures.12

This argument for flexibility was widely accepted, not without reason After all, complicatedaccounting questions sometimes had more than one solution But in winning the right to exerciseindependent judgment, accountants had escaped the responsibility to make sure the financialstatements for different companies would truly be comparable One accounting firm might encouragecompanies to write off losses from problem accounts very quickly, while a second allowed moreleeway

At the same time, individual firms refused to take professional responsibility for their supposedlyindependent judgments Management, not auditors, had the duty to ensure that a company’s financialstatements offered an honest presentation of its results, accountants said

“The primary responsibility for the selection of principles and the scope of disclosure mustremain that of the directors and officers of the corporation,” the American Institute of Accountantssaid in 1931 All accountants were required to do was make sure that a company had properlyfollowed the accounting rules it chose to use Auditors could certify financial statements even if they

thought a company had used the wrong accounting treatments, as long as they believed the companyhad acted in good faith, the A.I.A said.

So accountants had the upside of being professionals without the downside They insisted on theright to exercise independent judgment, but they also refused to take responsibility for the effects oftheir decisions They weren’t exactly clerks, but they weren’t “the foe of deceit and the champion ofhonesty,” either And they certainly weren’t independent

The passage of the securities laws and the creation of the S.E.C did little to change this dynamic

By requiring audited financial statements for many companies that had never had them before, the

1934 law created a huge new appetite for accountants’ services But the industry’s main concern formost of the 1930s seemed to be limiting the potential for lawsuits created by the legislation “A.I.A.members spent what appears to have been an inordinate amount of time debating terminology; forexample, would the use of the term ‘examination’ rather than ‘audit’ or ‘report’ rather than

‘certificate’ be helpful in limiting the profession’s legal liability?” Gary John Previts and Barbara

Dubis Merino wrote in A History of Accountancy in the United States: The Cultural Significance of

Accounting.13

By 1939 the disclaimers had reached absurd heights One auditor said that it could make “norepresentation whatsoever that there are no liabilities or obligations which are not shown in thebooks of the company.” Translation: Don’t blame us if you find out the company owes a couple ofhundred million dollars it didn’t mention We’re just the accountants

While Whitney and the S.E.C were chasing each other’s tails, and accountants acting as heroically asmight be expected, investors were delivering their own verdict on stocks It was not a happy one

After the panic lows of 1933, prices slowly recovered, along with the economy, through themiddle of the decade But they remained far below their 1929 highs, and investors remained bitterabout their losses, as Whitney discovered in 1935 when he toured the nation to tout the virtues ofstock ownership.14 Fred Allen, a well-known radio host, joked that Whitney’s campaign wouldfeature a young man telling his father that “I knew you didn’t have the rent, Daddy, so I took a dollarout of my bank to play the stock market I made a million dollars in ten minutes!” A few months laterthe exchange drew more jeers when it proposed appointing a “czar” who could help it regain thepublic’s trust

The last straw for many small investors came in 1937 and 1938 when stocks lost almost half theirvalue as the economy fell into its deepest trough since the early 1930s By then a generation ofinvestors had learned that stocks were too risky to own Bonds might pay only 2 or 3 percent, but atleast they offered a guaranteed return and a good night’s sleep What difference did the S.E.C.’sprotection make if the market kept falling?

“On summer days on Wall Street, things were so quiet that, walking down that famous canyon, allyou could hear through open windows was the roll of backgammon dice,” one veteran investmentbanker would recall a generation later.15 In April 1939, only 20 million shares changed hands on theBig Board, not many more than had traded on Black Tuesday alone By 1941 the number of individualshareholders had fallen to about 5 million, half the number of 1929.16

The situation grew even worse after America entered World War II In April 1942, with the wargoing badly, the Dow fell as low as 92.92, half its 1937 level and one-quarter its pre-crash peak And

as Washington mobilized the economy for World War II, Wall Street’s role in financing business allbut disappeared Companies essential to the war received loans from the federal government; othershad little hope of raising capital New issues of stock and debt plunged to $1 billion in 1942, one-tenth their 1929 levels.17 Stocks in the United States seemed headed for oblivion.

Beneath the surface, though, there were reasons for optimism

Even as individual investors turned away from the market, a small group of academics and moneymanagers started to think critically about the best ways to value stocks Over the next several years,they would create the foundations on which modern stock analysis is still based, and form the twogreat camps of investing, growth and value

The process began in 1934 when Graham and Dodd wrote Security Analysis The genius of

Security Analysis, the investors’ bible, is that it combines philosophy and practice The book teaches

investors both how to think about what a stock is worth and how to comb through financial statements

to find hidden values—and hidden traps Graham was the quintessential value investor, looking forout-of-favor companies with steady earnings and dividends He is sometimes accused of being tooskeptical of growth stocks and of focusing too much on balance sheets and not enough on the incomestatement In fact, Graham’s analysis was more nuanced All else being equal, he favored companies

with growing sales and profits, and he spent considerable time in Security Analysis explaining how

to read income statements Three years later, in The Interpretation of Financial Statements, his

second book, he would write, “It is only in the exceptional case that book value or liquidating valueplays an important role in security analysis.*7 In the great majority of instances the attractiveness orthe success of an investment will be found to depend on the earning power behind it.”

But having just lived through the bubble and bust, Graham believed that investors put too muchweight on short-term earnings trends, especially if they were strongly positive “We cannot be surethat a trend of profits shown in the past will continue in the future,” Graham wrote “The law ofdiminishing returns and of increasing competition must finally flatten out any sharply upwardcurve of growth There is also the flow and ebb of the business cycle, from which the particulardanger arises that the earnings curve will look most impressive on the very eve of a serioussetback.”18 Further, Graham warned, “There is no method of establishing a logical relationshipbetween trend and price This means that the value placed upon a satisfactory trend must be whollyarbitrary, and hence speculative, and hence inevitably subject to exaggeration and later collapse.”

So Graham focused on stocks where he could, as he later put it, “get the future for free.” Hisfavorite companies had steady or growing earnings and hard assets greater than the value of theirshares With stocks in the doldrums at the time the first edition was published, he had little difficultyfinding candidates, since many companies were selling for less than the cash they had on hand As themarkets recovered, the great bargains would disappear, and it would become harder to findcompanies that were extremely cheap and still had good managements and strong growth potential.Even so, Graham’s disciples, including Warren Buffett—a student of Graham’s at ColumbiaUniversity—continued to have success seeking out companies with solid balance sheets that had been

ignored by the market Security Analysis remains in print today, almost seventy years after its first

edition

In 1938, four years after Security Analysis first appeared, John Burr Williams, a doctoral student

at Harvard, tried to answer the question Graham had asked four years earlier: How should investors

value future earnings? In The Theory of Investment Value, Williams argued that stocks were no more

or less valuable than the future cash they produced for their shareholders, usually in the form of

dividends “A stock is worth only what you can get out of it A cow for her milk, a hen for her

eggs, and a stock, by heck, for her dividends.”19

Williams’s theory, which became known as the dividend discount model, makes intuitive sense,and it offers strong support for investing in growth stocks A company with rapidly rising dividendswill be worth much more over time than one whose payouts are flat or declining Unfortunately,actually putting the model into practice is difficult, because it depends crucially on three variables.First, investors need to figure out what future dividends will be Then they need to determine howsure they are of their predictions Finally, they must figure out how much to “discount” the futuredividends Discounting is necessary because a dollar received tomorrow is worth less than a dollar

in hand today But there is no magic formula to determine the discount rate for a particular stock Itdepends on both interest rates and how certain investors are about a company’s growth prospects

As a result, Williams’s model can be used to justify almost any price for a stock Increase theestimate of future dividends or lower the discount rate, and voila—shares that seemed expensive aresuddenly cheap Of course, careful investors can try to keep their estimates reasonable, but the modellends itself to easy optimism Further, as Graham and his disciples pointed out over and over, thefaster a stock is growing, the harder it is for investors to predict its future A railroad that has earned

$12 a share for the last decade will probably earn $12 a share for the next few years as well Butwhat about a company whose earnings have grown from 50 cents to $2 in five years? Will it grow atthe same rate for the next five, and earn $8 a share at the end of that time? What if economic growthslows or new competitors emerge?

Nonetheless, at least Williams provided an intellectual framework for valuing stocks based on

their future cash flows And his model was not inherently aggressive; investors who wanted to use it

conservatively could simply plug in a high discount rate to account for the natural uncertainty of futuredividends

Over the next few years, other money managers and analysts picked up on the threads laid byGraham and Williams A group of analysts, including Graham, began to meet monthly in New York atthe apartment of Helen Slade, a New York doyenne who served as a patron for the fledgling fraternity

of analysts Then, in 1945, Slade founded The Financial Analysts Journal, which became the center

of sophisticated debates over the best way to pick stocks as well as to create portfolios that wouldoutperform the overall market while minimizing risk The golden age of Wall Street research—such

as it was—was fast approaching

Even accounting began to improve, at least a little In 1938, police discovered a massive fraud atMcKesson & Robbins, a big drug company traded on the New York Stock Exchange and audited byPrice Waterhouse Executives at McKesson had embezzled more than $18 million, hiding their theft

by creating a fake division The fictitious unit represented almost one-fifth of McKesson’s totalassets, but Price Waterhouse somehow had managed to miss the fact that it didn’t exist (Clues to thefraud included a shipment that supposedly had been sent from Canada to Australia—by truck.)

The scope of the fraud, and the fact that it had involved Price Waterhouse, the most prestigiousaccounting firm, led the S.E.C to open a high-profile investigation of McKesson’s collapse Withheavy press coverage, the investigation quickly turned into a referendum on accounting and auditing

practices “The entire profession was, in effect, on trial,” one accounting historian later wrote.20Regulators and investors did not take long to reach a verdict, especially after accountants explained atthe hearings that audits did not have to include any inspection of real inventories An examination of a

firm’s records was good enough Accountants were professionals, not customs inspectors They

couldn’t be expected to dirty their shoes in the field

Faced with this attitude, the public and the S.E.C could be forgiven for wondering whyaccountants existed at all To the untrained eye, checking to make sure a company’s inventory is realcertainly seems like an auditor’s job The New York attorney general argued that accounting as awhole had “fundamental weaknesses” that needed to be addressed The industry had little choice but

to respond In 1939 the American Institute of Accountants issued new guidelines for auditing,requiring accountants to confirm that inventory and sales really existed The new rules also requiredthat auditors make sure a company’s internal financial controls were correct before relying on them

Perhaps more important, the hearings put the accounting industry on notice that investors andregulators expected accountants to be more than rubber stamps for management Although the hearingsdid not result in new federal rules governing accountants, they did raise the S.E.C.’s interest inaccounting standards Over the next several years the commission repeatedly jawboned accountingfirms to protect investors better In 1946, the S.E.C accused accountants of allowing wholesalegimmickry at smaller publicly traded companies whose financial reports did not have to be filed withthe commission And in 1948, when an accounting standard-setting committee proposed allowingcompanies to set aside reserves for future losses without having to specify what those losses would

be, the S.E.C threatened to take for itself the authority to set accounting standards, though it did notfollow through

The broader political climate during the 1940s also encouraged conservatism in financialstatements With a war on and a Democratic president, companies had no interest in appearing tomake too much money Auditors were, as always, glad to bend to their clients’ wishes For once,though, companies wanted to make their profits look smaller, not larger

So Wall Street had, in small but appreciable ways, changed for the better by the late 1940s To thepublic, though, it was still 1933 A 1948 poll by the Federal Reserve found that 90 percent ofAmericans were opposed to buying stocks.21 Asked why, about half said they were unfamiliar withstocks as an investment, while the rest said equities were “a gamble” and “not safe.”

In hindsight, the irony is immense In 1949, American stocks were as safe an investment as theywould ever be With Europe and Asia digging out from the war, the United States had the world’sdominant economy Foreign competition hardly existed for companies like General Electric Afterhaving suffered through the Depression, industrial America was lean and efficient—the bloat of the1960s and 1970s had not yet set in At the same time, with foreign competition weak, many Americanindustries had tacitly organized themselves into highly profitable cartels The average big industrialcompany had a return on capital of 18 percent, an amazingly high figure.22

The overall economic picture was equally bright Employment was high, and consumers had justbegun a post-Depression and postwar spending spree that still hasn’t ended The number of newhomes built in 1949 topped 1 million for the first time ever The Federal Reserve had kept interestrates low, so high-quality bonds were paying less than 3 percent About the only worry was inflation,

which had crept up slightly but was hardly an immediate threat Meanwhile, the creation of the S.E.C.and the work of Graham and other analysts had helped level the playing field for individual investors.Disclosure rules were stronger and accounting standards more uniform than they had been ageneration earlier Audited financial statements could be had at S.E.C offices or directly fromcompanies Small stocks could still be manipulated, but big companies were too closely watched andtoo widely held for a single market operator to dictate their price The markets may not have beenfair, but they were far fairer than they had been a generation earlier.

Yet stocks were dirt cheap, cheaper than they had been when the 1920s bull market began TheDow Jones industrial average fell as low as 161 in 1949, less than half its level two decades earlierand only 60 percent higher than it had stood in 1906 The average big stock sold for six times itsannual earnings and paid a dividend of almost 7 percent U.S Steel, with earnings of $5.39 a shareand a dividend of $2.25, traded as low as $21, giving it a P/E ratio of 4 and a dividend yield of 11percent

Put another way, $1 invested in stocks in 1949 bought 16 cents of corporate earnings, 7 cents ofcash dividends, and the chance to share in the growth of the world’s dominant economy $1 invested

in bonds bought not quite 3 cents of interest at a time when the risk of inflation, which is death tobonds, was rising

A bear market is the opposite of a bull market Wall Street has no word for the opposite of abubble, but it should Because what happened over the course of the 1940s, especially toward the end

of the decade, was the opposite of a bubble It was not exactly a bust A bust is the end of a bubble,not the opposite And it was not exactly a bear market, because stocks were not falling They justwere not rising, when in retrospect it is obvious that they were a screamingly good investment

But bubbles and antibubbles, for lack of a better word, have one thing in common: Neither lastsforever Eventually smart investors, small and large, see that stocks are too cheap not to buy Theyhold their noses, ignore the conventional wisdom, fight their fear, and get back in As one investor

told the New York Post in 1950, “The salesman showed me in black and white how much better I

would have been if I had bought his [mutual] fund instead of keeping my cash in the bank.”23

And so on June 14, 1949, the second great bull market of the twentieth century began By the end ofthat year the Dow had risen to 200 Three years later it stood at 290 After a lull in 1953, the marketsoared 44 percent in 1954, one of its best years ever On November 17, 1954, the Dow finallycracked its 1929 highs, and jubilation and concern mixed on Wall Street Were the gains real? Or wasanother crash coming? The public’s lingering mistrust of the market spurred two congressionalinvestigations of the nascent boom Ben Graham patiently explained the mysteries of high finance tothe Senate Banking and Currency Committee:

SENATOR: Could you explain some terms to us? Could you tell us what is meant by profit taking?

GRAHAM: Well, profit taking is very simple It means that people who have a paper profit in theirshares realize that paper profit by selling

SENATOR: Is that similar to a sell-off?

GRAHAM: Well, a sell-off is simply a decline, presumably temporary, in the market, for any number ofreasons Profit taking may be the reason advanced, or a war scare, or something that happens inthis committee room or anything else

SENATOR: Or a technical adjustment is another term?

GRAHAM: The technical adjustment is very likely related to profit taking.24

(One can only imagine that Graham was trying to keep a straight face by this point He knew aswell as anyone that “profit taking” and “technical adjustments” were, and still are, Wall Street jargonfor “I have no idea why the market went down today.”) Meanwhile, Harvard economist John KennethGalbraith, for the first time but not the last, warned of another 1929 But the boom had only begun.The Dow ended 1959 at 679, more than triple its level in 1950 It was the best decade ever for U.S.stocks

And somewhere along the way, investors forgot that they hated Wall Street To the contrary: At atime when the Soviet Union was the United States’ mortal enemy, George Funston, the new president

of the New York Stock Exchange, declared the Big Board a center of “people’s capitalism,” as ifevery American had a moral obligation to buy stocks “The way to fight communism is throughAmerican prosperity,” Funston said “We’re trying to broaden the basis for share ownership and thusstrengthen the basis of democracy.”25 At the same time, brokerage firms, led by Merrill Lynch,reached out to the growing market of middle-class Americans who wanted to save for theirretirements and their children’s educations In the late 1940s, Merrill had begun to run six-thousand-word newspaper ads explaining “What Everybody Ought to Know About the Stock and BondBusiness.” The advertisements introduced millions of Americans to stocks.26

Of course, Funston’s slogans and Merrill’s education campaigns might have met a less friendlyaudience had stocks not been soaring As it was, the publicity came at a perfect time The market’srise attracted new investors who put fresh cash into stocks, causing the market to rise and attractingnew investors et cetera, ad infinitum Surveys by the New York Stock Exchange showed thenumber of Americans who owned stocks steadily rising during the 1950s In 1952, about 6 millionAmericans, one in sixteen adults, owned stocks By 1961, 17 million did

The modern market—large, liquid, and of great importance to Main Street—had been born

Chapter 3

Bubbling Under

Bear markets have villains Bull markets have heroes Bull markets need heroes, living talismans to

be rubbed for luck And as the 1960s dawned and stocks continued their rise, Gerry Tsai became thefirst hero of the post-crash bull market Traders and investors scrambled to follow his moves He wasthe heir to the manipulators of the 1920s, a man with the power to make stocks dance

Even better, Gerry Tsai was no mere stock operator on the fringes of the market and the law Hewas a mutual fund manager, one of a new breed of professional investors whose importance hadsoared during the 1950s

Mutual funds had first become popular during the 1920s boom, when they were known asinvestment trusts Run by full-time managers, the funds theoretically offered small investors thechance to own a diverse basket of stocks at low cost But they had performed pitifully during the bust,and as Wall Street fell into its post-crash doldrums, they faded into insignificance

Then the market turned Seeing the chance to win a new generation of investors, fund companiesrecruited sales representatives to peddle their funds for commissions that could run as high as 8.5percent Sometimes the funds were sold in multi-year investment plans, with all commissions paid upfront, an arrangement that meant that new shareholders could lose half of their first year’s investment

to commissions (Eventually, the S.E.C discouraged that practice.) But what was bad for the investorwas good for the salesman; by the late 1950s, tens of thousands of Americans had signed up to sellmutual funds part-time “Elementary and high school teachers would try to sell fund plans to parents

of students, and clergymen would do the same for members of their congregations High-pressuretactics were the rule.”1

The tactics worked In 1950 there were fewer than 100 mutual funds, with 939,000 accounts and

$2.5 billion in assets A decade later there were 161 funds, with 4.5 million accounts and $17 billionunder management.2

As the funds grew, so did their influence and the attention they received By the early 1960s nomanager was better known than Tsai, who had run the Fidelity Capital Fund since its inception in

1957 Tsai was a risk-taker personally and professionally; his hobbies included helicopter flying, atleast until he crash-landed in the Hudson River.3 On Wall Street he made his name buying fast-growing “glamour stocks” like Xerox and Polaroid At a time when most investors hardly traded,Tsai rotated his portfolio quickly Most important, he beat the market, cementing his reputation at theend of 1962, when he gained 68 percent in three months By then, “many people seemed to believe hepossessed mystical powers of the Orient (he was born in Shanghai) which somehow enabled him toperceive the future Rumors that TSAI IS BUYING! and TSAI IS SELLING! usually caused a

desperate scramble to follow his lead,” Institutional Investor magazine wrote.4Institutional Investor also noted that Newsweek and other magazines, which should have known better, had,

inevitably, referred to Tsai as “inscrutable.” In fact, Tsai was “eminently scrutable His gaze,furthermore, is not blank, but rather animated, and when the occasion warrants, stern and cutting,”

Institutional Investor noted.

Scrutable or not, Tsai—and his imitators—would be a major factor in a surge of aggressiveaccounting during the 1960s that presaged the much more serious problems that followed a generationlater

In theory, the rise of mutual funds should have been a boon for Wall Street Run by professional, time managers, the funds should have been immune to the frenzies that swamped individual investors.They could even have been a force for better corporate governance No longer would shareholders bepowerless; a few large funds could together control 20 percent or more of a company, enough to have

full-a credible threfull-at of ousting its mfull-anfull-agement if they chose

But the explosion in funds was as much curse as blessing The sad truth is that most investmentprofessionals do not know much more—either about the individual stocks they own or the broadmarket—than smart individual investors There are exceptions Some managers, especially those withdecades of experience, really have learned how to take the market’s swings in stride Some haveuncanny success at finding obscure companies that are fast-growing, or cheap, or both Some havespent so much time investing in one sector that they know it as well as any chief executive does Afew can look at a company’s financial statements and sniff out hidden values or hidden fraud

A handful of managers puts those skills together, combining an eye for value with anunderstanding of industry cycles and an intuition about the truth of financial statements They talk tocompetitors, suppliers, distributors, retailers They read trade magazines They are the first to hearthat the senior vice president for sales has quit, and the first to find out why They spend weekendsreading 10-Ks, not golfing with management They are unafraid to stand apart from the crowd orsuffer through periods when they trail the averages

But most fund managers do not have the brains or the courage to be independent The averagemanager knows enough about the stocks he owns that he doesn’t look foolish to his equally busy boss,

or to a reporter who calls on a day when the Dow is down 3 percent He knows the hot products inhis companies’ pipelines He remembers what earnings were for the last two quarters and what theyare supposed to be for the next two He sees management at conferences twice a year; he recognizesthe CEO, chief financial officer, maybe a couple of divisional heads And that’s about it Not bad for

a guy keeping track of 150 companies, a guy who has to make a morning presentation in St Louis tothe brokers selling his fund and have dinner in Detroit at an auto industry conference

The average manager spouts the happy lingo that all fund managers pick up when they make theirfirst trade He is looking for “growth at a reasonable price,” for stocks that are “on sale,” formanagements with “bench strength,” and companies that are “leaders in their space.” But does hehave any real insight, either into the stocks he owns or the market’s overall action? Does he actually

know anything?

No

In fact, many academics argue that investors, both professional and individual, are simply wastingtheir time by trying to beat the market Their theory, known as the efficient market hypothesis, holds

that stock prices always incorporate all the information that is known about a company at any giventime No single investor, however wise, can outsmart the collective intelligence of tens of millions ofpeople.

Put another way, the efficient market hypothesis is that the market is always right Prices changeonly in response to new information about a company’s prospects, and new information is bydefinition unknowable before it happens Investors who seem to be beating the market are actuallyjust getting lucky or taking on extra risk

If the efficient market hypothesis is true, then the mutual fund industry shouldn’t exist Smallinvestors would be far better off giving their money to index funds, which are “passively managed”and simply follow indexes like the S&P 500 Index funds are cheaper to run than actively managedfunds, so unless professional managers can beat the market as a group (presumably by outsmartingindividual investors, their collective competition), small investors shouldn’t pay for active managers.And, in fact, index funds do beat actively managed funds The S&P 500 has outperformed the averagefund in fifteen out of the last twenty years, and that figure doesn’t include the upfront sales chargesthat most funds charge.5 Between 1981 and 2001, the average fund trailed the S&P 500 by more than

3 percentage points a year; the S&P 500 rose 14.9 percent annually, the average fund only 11.5percent Yet the mutual fund industry continues to grow, and index funds remain only a small part of

it Mutual funds may be dead in theory, but they are very alive in fact Efficient market theory haslittle influence on the way people actually invest

So is the theory correct? I personally don’t think so Outperforming the market is hard, and themore one trades, the harder it is, because trading is expensive But just because most investors lag theaverages does not make beating them impossible Warren Buffett has consistently outperformed theS&P 500 for the last forty years, and he is not alone And it is notable that, like Buffett, many of theinvestors with great long-term records either studied with or worked for Ben Graham “I’mconvinced that there is much inefficiency in the market,” Buffett said in a 1984 speech about “TheSuper-Investors of Graham and Doddsville.” “Market prices are frequently nonsensical.”

(But there is a second, “weaker” version of the theory supported by lots of research The weakversion argues that the future direction of a stock can’t be predicted simply from its previous pricemovements In other words, technical analysis, a.k.a charting, is a joke Chartists have all sorts offancy names for the squiggles that stocks create as they rise and fall: the “head and shoulders,” the

“double-top,” the “false bottom.” But anyone who listens carefully to a chartist will eventuallydiscover that his prophecies are always the same: If a stock is going up, it will keep going up, unless

it stops going up, in which case it will go down for a while At that point it may start to go up again,

or maybe keep going down If the stock is going down, the prediction will be the same, in reverse.The fact that so many investors take technical analysis seriously is strong evidence that the marketmay not be so efficient after all.)

Another big plus that funds supposedly offer, the ability to fight for better corporate governance, alsoturns out to be largely fictional A fund can’t control a company through 5 percent ownership, or 10percent Only if it launches a serious takeover attempt—or spends years publicly pointing outmanagements’ flaws—will its complaints be taken seriously And mutual funds are not interested intakeover battles or drawn-out fights with companies As fund managers will gladly explain, they’repaid to pick winning stocks, not run companies If they dislike the way a company is run or have

questions about its accounting, they usually just sell and move on With so many stocks to choosefrom, why get stuck with the losers?

At the same time, funds are saddled with perverse incentives that can actually raise their risks toindividual investors First off, when individual investors buy a stock, they are putting their ownsavings at risk Fund managers aren’t, so they may be more willing to take chances than the individualinvestors they supposedly represent Further, with so many funds competing for investors’ attention,the only way for a fund to stand out is with exceptional returns Not good returns Exceptional returns.Buying out-of-favor companies and waiting for the market to see their hidden value doesn’t stand out.Beating the market by 2 percent—or even 3 percent or 5 percent—a year doesn’t stand out, not untilyou’ve done it for a decade or so

What stands out? Buying companies whose sales are growing 50 percent a year, whose profits aredoubling, and whose stock is tripling Financial magazines look for managers who can do that as

eagerly as Vogue searches out new supermodels The tale of the heroic fund that has tamed the beast

of the market and racked up 100 percent annual returns is guaranteed to move copies

So returns mean press, and press means new investors And because a fund’s management feesare usually calculated as a percentage of its total assets, new investors mean more money for the fundcompany—and the manager But to have a chance of exceptional returns, a manager must almostalways take on exceptional risk He may be nạve and not understand the risk he’s taking He may becynical and figure it’s not his problem if he loses Either way, he has every reason to make big bets

on high-growth companies

Unfortunately, novice investors often don’t understand fund managers’ hidden motives In fact,they are usually taught to think of funds as safer than stocks, because funds are diversified Owningjust one or two stocks is inherently risky; your savings can disappear overnight if a company has anunexpected crisis Owning a fund eliminates that possibility

But the incentives that encourage fund managers to take big risks also encourage them to buystocks that rise and fall together To get great returns, a fund needs to own stocks that tend to move intandem Having one stock that rises while another falls won’t do the trick So in the real world, fundsare often less diversified than they appear to be, and they can fall as quickly as they rise Individualinvestors rarely learn that unfortunate fact until it’s too late

The fund industry’s hidden dangers would not be exposed until the end of the 1960s But the broadmarket showed unmistakable signs of speculation much earlier The market’s rise during the 1950shad far outstripped growth in corporate profits and dividends As a result, by 1960 the average bigstock had a price-earnings ratio of 20 and a dividend yield of 3 percent Stocks were no longer theonce-a-century bargain they had been in 1949 By historical averages they were somewhat expensive

—although not absurdly overvalued

Yet at a time when caution was appropriate, the same investors who had avoided stocks a decadeearlier suddenly piled in As in the 1920s, a few good years turned fear into greed Almost one in fourpotential investors in a 1959 New York Stock Exchange survey said the main reason to buy a stockwas “opportunity for quick profit.”6 By 1960, the sturdy blue-chip companies that had led the Dowand S&P 500 higher during the 1950s began to fall out of favor The market’s new leaders weresmaller, less seasoned companies with more potential—and more risk With the digital age justbeginning and the federal government throwing billions of dollars into space and defense research,

companies like Texas Instruments and Honeywell soared As early as 1959, one professional investormocked Wall Street’s infatuation with technology and defense companies:

Take a nice little company that’s been making shoelaces for 40 years and sells at arespectable six times earnings Change the name from Shoelaces, Inc., to Electronics andSilicon Furth-Burners In today’s market, the words “electronics” and “silicon” are worth 15times earnings However, the real play comes from “furth-burners,” which no oneunderstands A word that no one understands allows you to double your entire score.Therefore, we have six times earnings for the shoelace business and 15 times for theelectronics and silicon, or a total of 21 times earnings Multiply this by two for furth-burners,and we now have a score of 42 times earnings for the entire company.7

In 1954 investors were so unfamiliar with the concept of growth stocks that The Wall Street

Journal found it necessary to describe what one was: “The good growth company, experience shows,

may pay out only a small part of its earnings in cash dividends, using the rest for research,development of new products, and expansion The plowed-back earnings should bring largerearnings power.”8

Now growth stocks needed no explanation With investors looking for the next Motorola orXerox, Wall Street’s burgeoning research community began to seek out stocks with strong growthpotential While quarterly earnings reports were still rare, in 1955 the S.E.C had requiredsemiannual earnings reports (Between 1946 and 1953 the commission required, oddly, thatcompanies report their sales but not their profits every quarter.) The increased flow of financialinformation contributed to investors’ interest in earnings and in analysts’ projections Membership inthe Financial Analysts Foundation surged from three thousand in 1951 to eleven thousand a decadelater.9 Some analysts became minor celebrities In 1962, Newsweek profiled six of the “most

influential on Wall Street: Men who know the companies, know the market—and often know thefuture.” One of the six touted Montgomery Ward as the next Chrysler (he was right, but not the way hemeant), while another joked that “stocks are basically like sex—timing is everything.” For the firsttime, companies could be penalized if they did not meet analysts’ expectations

It would not grow into a monster for another generation, but the cult of the number had been born

The good times paused in 1962, when a heavy-handed attempt by President Kennedy to restrain steelprices caused the Dow to skid 28 percent in six months But after the Cuban Missile Crisis ended inOctober, the market began another broad rally New investors rushed to join in as the stocks climbedhigher “Young and middle-aged investors now felt they had gone through the fire and survived To ageneration that had not known the pains of a truly severe panic and crash, the 1962 experience seemedfrightening, but quite bearable,” market historian Robert Sobel wrote.10 By 1965 more than 20 millionAmericans owned stocks, a rise of 4 million in four years Investors eagerly watched the Dow close

on 1,000; the four-digit barrier seemed sure to fall in 1966

As the market grew more frenzied, investors became focused on the earnings magic of a group offast-growing companies called conglomerates Their decade-long rise and fall would offer proof, ifany was needed, that the reforms of the New Deal had not fundamentally changed the market.Investors remained irresistibly attracted to companies that appeared to show strong profit growth.And S.E.C or no S.E.C., accountants and investment bankers were willing to help companies commit

what was essentially legalized fraud to create that growth.

The conglomerates first became popular in the late 1950s They specialized in taking over othercompanies and increasing their profits, supposedly with superior management The trend started withLitton, a defense contractor that increased its sales from $15 million in 1956 to almost $1 billion by

1964 by getting into shipbuilding and dozens of other businesses Many other companies followed;the most aggressive of all was Ling Industries, which became Ling-Temco and then Ling-Temco-Vought L-T-V increased its sales from $7 million in 1958 to $3.8 billion in 1969 Its earnings grewfrom 83 cents a share in 1960 to $5.56 in 1967.11

By the end of the 1960s, L-T-V was the fourteenth largest industrial company in the United States,and nine other conglomerates were in the top 200 L-T-V’s chairman, James Ling, and the other

“conglomerateurs” had become the first genuine business celebrities since Henry Ford and theindustrial barons of the early twentieth century General Motors and U S Steel were lethargicbureaucracies, out of step with a nation that increasingly celebrated individual dissent.Conglomerateurs were the rebels of the Fortune 500 They flaunted their wealth; Ling built a $3million Dallas mansion that included a $14,000 marble bathtub, and he publicly took inspiration forhis business tactics from Marshal Erwin Rommel, the brilliant desert commander of World War II.12Never mind that Rommel had fought for the Germans The war was over The conglomerateurs werenew managers for a new era Their results proved their strategy

But those results were a myth, a miracle of accounting that had nothing to do with real-worldbusiness acumen Any company with a high price-earnings ratio can cause its earnings to rise simply

by buying another company whose stock is cheaper than its own.*8 The only management skills theconglomerateurs needed were a high stock price and a steady supply of cheap companies to buy

Finding those takeover targets became more difficult as the 1960s progressed Many obviouscandidates had already been bought; others were trying to become conglomerates themselves Tokeep the acquisition binge alive, conglomerates relied on accounting and financing gimmicks to hidethe cost of their takeovers By the middle of the decade they had discovered ways to makeacquisitions for what seemed to be no cost at all Under the accounting rules in place at the time, thesegimmicks were not considered a violation of generally accepted accounting principles, much lessfraud But they should have been They hid the conglomerates’ liabilities and vastly overstated theirincome

It should come as no surprise that accountants had little interest in stopping them Following itsfavorite strategy of death by delay, the accounting industry had debated better ways to account formergers since 1960 In December 1966 the Accounting Principles Board—the industry’s standard-setter—proposed a change that would have made the conglomerates’ favorite trick much moredifficult Faced with opposition from accounting firms and conglomerates, the board backed off.13Two years later a study by the American Institute of Certified Public Accountants also proposedtighter rules.*9

By then the conglomerate boom had just about peaked The problems with merger accountingwere obvious, and many investors had realized that conglomerate profits were inflated The end came

in 1969, when the market plunged, making it hard for conglomerates to issue the debt or stocks theyneeded for new acquisitions A conglomerateur who runs out of acquisitions is a very unhappyconglomerateur He’s stuck managing the companies he has already bought, which are all too oftenthird-rate companies in slow-growth industries Winners buy; losers manage Worse, the skills that

make a successful conglomerateur—salesmanship, impatience with details, and a huge ego—are more

or less the opposite of the skills needed to successfully manage a company

The highest flier fell hardest By 1969, L-T-V reported a loss of $10.69 a share James Ling wasasked to seek other employment, and L-T-V rapidly undid his acquisition spree Still, L-T-V’s lossreached $17.18 a share in 1970 The company’s stock fell from $169 in 1967 to $7 three years later.From 1969 to 1971 the stocks of ten major conglomerates fell an average of 86 percent.14

The accounting industry took no action to tighten the rules on merger accounting until August

1970, when the Accounting Principles Board made a change so weak that it was derided as irrelevant

by several of its members The foot-dragging meant that “billions of dollars of economic activity wasaccounted for in a manner that almost literally everyone knew was an inadequate and sometimesdownright misleading method,” A A Sommer, a lawyer and future S.E.C commissioner, wrote in

1970.15

But what did Sommer expect? The conglomerates had no interest in rules changes that would hurt

their reported profits, and the conglomerates were very good clients of the accounting industry In The

Go-Go Years, his tale of the market in the 1960s, the inimitable John Brooks summed up the mysteries

of conglomerate accounting with a phrase only a New Yorker writer could get away with:

Another effect was to confuse everyone concerned, and it cannot be said that the confusionwas always entirely accidental; often enough it was plainly intended to throw dust in the eyes

of the average investor with his tunnel vision trained on the bottom line By followingconservative practices and their consciences, accountants could have prevented most of thisjiggery-pokery; they did not.16

Neither did the mutual fund industry In fact, quite the reverse Managers such as Gerry Tsai, whowanted earnings growth and did not particularly care where it came from, were early and avidsupporters of the conglomerates, ignoring the obvious red flags raised by their accounting gimmicks

In the introduction to The Money Managers, a 1969 book that profiled nineteen top institutional

investors, “Adam Smith” (the pseudonym for George J W Goodman, a money manager) wrote thatmanagers now “live in the Age of Performance Performance means, quite simply, that your portfoliodoes better than the others If the market goes up, the performance portfolio goes up more If themarket goes down, the performance portfolio goes down less.”17

The theory sounded reasonable Who wouldn’t want a fund that rose more than the market on theway up and lost less on the way down? But between 1949 and 1968, stocks had fallen more than 20percent only once, in 1962 In that environment, only one kind of performance mattered—the kind onthe way up Smith said as much as few sentences later: “Most of these professionals no longer think

of their mission as preserving capital They think of it as making money Those are two sharply

different states of mind.” (Italics in the original.) And so by the late 1960s, Tsai and his imitators hadgravitated to conglomerates, computer and electronics companies, and the newest trend stocks of all,franchisers With inflation rising and the Vietnam War escalating, the rest of the market was stagnant,

or worse

Did fund managers understand the games the conglomerates were playing? The question is almostirrelevant If they didn’t, they should have Professional money managers are paid to divine whetherearnings growth is real or manufactured Those who ignore aggressive accounting are guilty of